Does Religion Matter to Equity Pricing?

Abstract

For a sample comprising 36,105 U.S. firm-year observations from 1985 to 2008, we find that firms located in more religious counties enjoy cheaper equity financing costs. This result is robust to a battery of sensitivity tests, including alternative assumptions and model specifications, additional controls for noise in analyst forecasts, and various approaches to addressing endogeneity. In another set of tests, we find that the equity pricing role that religion plays comes predominantly from Mainline Protestants. We also document that the effect of religiosity on firms’ cost of equity capital is larger for firms (periods) lacking alternative monitoring (regulation) mechanisms as measured by lower institutional ownership (the pre-SOX era), implying that religion plays a corporate governance role. Finally, we find that the importance of religion to equity pricing is concentrated in firms that suffer lower visibility, which tend to be more sensitive to local social and economic factors. By examining the links between religiosity and valuation at the firm level, we provide strong, robust evidence supporting the perspective that religion facilitates economic development.

Appendices

The description of the models and notations used in the appendix follow El Ghoul et al. (2011).

Appendix 1: Models of Cost of Equity Capital

The description of the models and notations used in the appendix follow El Ghoul et al. (2011).

In this appendix, we describe the cost of equity models used in this article. We start by defining variables and specifying assumptions common to all models. We then successively cover each model and its assumptions.

Common Variables and Assumptions

• P _t  = stock price in June of year t

• DPS ₀ = actual dividend per share in year t − 1

• EPS ₀ = actual earnings per share in year t − 1

• LTG = long-term growth forecast in June of year t

• FEPS _t+τ  = forecasted earnings per share for year t + τ recorded in June of year t

• B _t  = book value per share at the beginning of year t

• r _f  = yield on a 10-year Treasury note in June of year t

As explained in the text, we require firms to have positive 1-year-ahead (FEPS _t+1) and 2-year-ahead (FEPS _t+2) earnings forecasts as well as a long-term growth forecast (LTG). Yet, the two models call for the use of earnings forecasts beyond year 2. If a forecast is not available in I/B/E/S, then we impute it from the previous year forecast and the long-term growth forecast as FEPS _t+τ  = FEPS _t+τ−1(1 + LTG).

Model 1: Ohlson and Juettner-Nauroth (2005)

The model is a generalization of the Gordon constant growth model. It allows share price to be expressed in terms of 1-year-ahead earnings forecast, near-term, and perpetual growth forecasts. The explicit forecast horizon is set to 1 year, after which forecasted earnings grow at a near-term rate that decays to a perpetual rate. We follow Gode and Mohanram (2003) implementation of the model. The near-term earnings growth is the average of (i) the percentage difference between 2-year-ahead and 1-year-ahead earnings forecasts, and (ii) the I/B/E/S long-term growth forecast. The perpetual growth rate is the expected inflation rate. Dividend per share is assumed to be constant. The model requires positive 1-year-ahead and 2-year-ahead earnings forecasts. The valuation equation is given by

$$ k_{\text{OJ}} = A + \sqrt {A^{2} + \frac{{FEPS_{t + 1} }}{{P_{t} }}\left( {g_{2} - \left( {\gamma - 1} \right)} \right)} $$

(1)

where $A = 1/2\left[ {\left( {\gamma - 1} \right) + \left( {DPS_{t + 1} } \right)/P_{t} } \right]$, DPS _t+1 = DPS ₀, g ₂ = (STG + LTG)/2, STG = (FEPS _t+2 − FEPS _t+1)/FEPS _t+1, and (γ − 1) = r _f  − 0.03.

Model 2: Easton (2004)

This model is a generalization of the Price-Earnings-Growth (PEG) model and is based on Ohlson and Juettner-Nauroth (2005). It allows share price to be expressed in terms of 1-year-ahead expected dividend per share, and 1-year-ahead and 2-year-ahead earnings forecasts. The explicit forecast horizon is set to 2 years, after which forecasted abnormal earnings grow in perpetuity at a constant rate. The model requires positive 1-year-ahead and 2-year-ahead earnings forecasts as well as positive change in earnings forecast. The valuation equation is given by

$$ P_{t} = \frac{{FEPS_{t + 2} + k_{\text{ES}} DPS_{t + 1} - FEPS_{t + 1} }}{{k_{\text{ES}}^{2} }} $$

(2)

where DPS _t+1 = DPS ₀.

Model 3: Claus and Thomas (2001)

This model assumes clean surplus accounting (Ohlson 1995), allowing share price to be expressed in terms of forecasted residual earnings and book values. The explicit forecast horizon is set to 5 years, beyond which forecasted residual earnings grow at the expected inflation rate. Dividend payout is assumed to be constant at 50%. The valuation equation is given by

$$ P_{t} = B_{t} + \mathop \sum \limits_{\tau = 1}^{5} \frac{{ae_{t + \tau } }}{{\left( {1 + k_{\text{CT}} } \right)^{\tau } }} + \frac{{ae_{t + 5} \left( {1 + g} \right)}}{{\left( {k_{\text{CT}} - g} \right)\left( {1 + k_{\text{CT}} } \right)^{5} }} $$

(3)

where ae _t+τ  = FEPS _t+τ  − k _CT B _t+τ−1, B _t+τ  = B _t+τ−1 + FEPS _t+τ (1 − DPR _t+τ ), DPR _t+τ  = 0.5, and g = r _f  − 0.03.

Model 4: Gebhardt, Lee, and Swaminathan (2001)

This model also assumes clean surplus accounting, allowing share price to be expressed in terms of forecasted returns on equity (ROE) and book values. The explicit forecast horizon is set to 3 years, beyond which forecasted ROE decays to the median industry ROE by the 12th year, and remains constant thereafter. Dividend payout is assumed to be constant. The valuation equation is given by

$$ P_{t} = B_{t} + \mathop \sum \limits_{\tau = 1}^{11} \frac{{FROE_{t + \tau } - k_{\text{GLS}} }}{{\left( {1 + k_{\text{GLS}} } \right)^{\tau } }}B_{t + \tau - 1} + \frac{{FROE_{t + 12} - k_{\text{GLS}} }}{{k_{\text{GLS}} \left( {1 + k_{\text{GLS}} } \right)^{11} }}B_{t + 11} $$

(4)

where FROE _t+τ  = forecasted return on equity for year t + τ, B _t+τ  = B _t+τ−1 + FEPS _t+τ (1 − DPR _t+τ ), and DPR _t+τ  = expected dividend payout ratio in year t + τ.

For the first 3 years, FROE _t+τ is set equal to FEPS _t+τ /B _t+τ−1. Beyond the third year, FROE fades linearly to industry median ROE by the 12th year. Industries are defined according to Fama and French’s (1997) 48 industry classification, and the median industry ROE is calculated over the previous 10 years excluding loss firms.

The expected dividend payout ratio DPR _t+τ is set equal to DPS ₀/EPS ₀. If EPS ₀ is negative, then it is replaced by the value implied by a 6% return on assets (the long-run return on assets in the U.S.). We winsorize payout ratios at zero and one.

Alternative Models

We also consider alternative models of the cost of equity. These are used in Table 8.

Gordon Infinite Horizon model

This model assumes that dividends grow in perpetuity at a constant rate, g. Assuming that g = LTG, the valuation equation is given by

$$ k_{\text{IHG}} = \frac{{DPS_{1} }}{{P_{t} }} + LTG $$

(5)

Gordon Finite Horizon Model

This model assumes that dividends grow over an explicit forecasting horizon set to 4 years, beyond which the firm’s return on equity reverts to the expected cost of equity capital. The valuation equations are given by

$$ P_{t} = \mathop \sum \limits_{\tau = 1}^{4} \frac{{DPS_{t + \tau } }}{{\left( {1 + k_{\text{FHG}} } \right)^{{{\uptau}}} }} + \frac{{NEPS_{t + 1} \left( {1 + LTG} \right)^{4} }}{{k_{\text{FHG}} \left( {1 + k_{\text{FHG}} } \right)^{4} }} $$

(6)

where DPS _t+τ  = DPS ₀(1 + LTG)^τ and $NEPS_{t + 1} = \frac{{FEPS_{t + 3} }}{{\left( {1 + LTG} \right)^{2} }}.$

Price-Earnings-Growth (PEG) Ratio

This is a special case of the Easton (2004) model assuming no dividend payments. There are two versions of the model. One is based on short-term earnings forecasts and the other on long-term earnings forecasts. The valuation equations are given by

$$ P_{t} = \frac{{FEPS_{t + 2} - FEPS_{t + 1} }}{{k_{\text{ES}}^{2} }} $$

(7)

$$ P_{t} = \frac{{FEPS_{t + 5} - FEPS_{t + 4} }}{{k_{\text{ES}}^{2} }} $$

(8)

Earnings-Price (EP) Ratio

This is a special case of the Easton (2004) model assuming that abnormal earnings growth is set to zero.

$$ EPR = \frac{{FEPS_{t + 1} }}{{P_{t} }} $$

(9)

Appendix 2

See Table 12.

Table 12 Regression variable definitions and data sources